Should an investor invest in individual securities or use funds?

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Stock and bond mutual funds have been popular among investors,
and record amounts have been invested in them over the years.
The advantages of mutual funds, as stated earlier in this chapter,
are the use of professional management, diversification, the freedom
to invest small amounts of money, and the ease of buying and
selling. For many investors, these advantages far outweigh the disadvantages
of mutual funds.

Mutual funds might be the most practical way for investors to
buy many types of securities, including bonds that sell in high
denominations (minimum investments of $50,000) and to build a
diversified portfolio of stocks. The decision of which individual
stocks to invest in can be avoided by choosing equity mutual funds.

Diversification achieved by mutual funds minimizes the effect
of any unexpected losses from individual stocks in the portfolio.
Also, the professional managers of these funds have quicker access
to information about the different issues. The managers might react
sooner in buying or selling the securities in question.

However, in certain cases, a strong argument exists for buying
individual securities over mutual funds. The rates of return on
individual stocks and bonds are often greater than those earned
from mutual funds. This statement is true even for no-load funds
because in addition to sales commissions, other fees, such as
12(b)–1 and operating fees, reduce the returns of mutual funds. By
investing in individual securities, you avoid these fees. A study by
Malkiel (1995, pp. 549–572) during the period 1971–1991 on the
performance of equity mutual funds indicates that on a yearly
basis throughout this period, the top-performing funds in one year
could easily become underperforming funds in the next year. This
phenomenon occurred more in the 1980s than in the 1970s.

Easy to buy and sell stocks at real-time prices during the trading day. More difficult to buy bonds

Easy to buy and sell shares. Trades occur only at the closing price at the end of the day

Professional management

No

Yes

Expenses and costs to buy and sell

Brokerage fees to buy and sell.

Low to high expenses depending on fund.

Tax planning

Easier to predict income and plan capital gains and losses.

Can upset careful tax planning owing to unpredictable distributions of
income and capital gains.

If you have a small amount of money to invest, mutual funds
are a better alternative. A $2,000 investment in a stock fund buys a
fraction of a diversified portfolio of stocks, whereas for individual
securities this amount might allow for buying only the shares of
one equity company. Investing in mutual funds is good strategy if
you do not have enough money to diversify your investments and
do not have the time, expertise, or inclination to select and manage
individual securities. In addition, a number of funds offer you the
opportunity to invest in the types of securities that would be difficult
to buy individually. Table 14–8 compares some characteristics of investing in individual
securities versus mutual funds.